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Liability-driven investing (LDI): The practice of focusing on liabilities in the course of setting and carrying out investment strategies. On this we all agree. But while the meaning of LDI has stayed constant in recent years, the implementation of it has evolved—as it should—in line with fluctuating market conditions, opportunities, and increased knowledge within pension funds.
First, there were the early adopters. These schemes did not hold on to misconceptions about mean reversion of yields, like many others did. They set themselves up with governance structures that enabled efficient and robust investment decision-making and were led by consultants who helped make good decisions. These schemes began to implement their LDI hedges four or more years ago, and they usually took the form of interest-rate and inflation-swap programs. A pool of conventional and index-linked bonds would be held to provide collateral for the swaps, as well as some hedging exposure. They began to build their interest rate and inflation hedges with the aspirational goal of being hedged to their funding level measured on a swap or gilt curve basis.
Despite sounding like an obvious step to some, misconceptions and behavioral anchoring have traditionally been the barriers to LDI adoption. Over the years, however, as hedged schemes achieved better funding levels with less risk, these barriers have been broken down. In their place has grown the idea that effective management of pension schemes starts by hedging the largest risks.
Over the last few years LDI has moved from a regime of “building the hedge” to one of “LDI as completion manager role.” Under this new arrangement, an LDI manager maintains the hedge ratio in pre-defined bounds around the target level. The manager takes into account the hedging properties of externally held portfolios such as corporate bonds, and uses his discretion on a number of factors—choosing gilts or swaps, positioning along the curve, and trading around such market events as gilt syndications or buy-backs. The aim is to exploit market dislocations and execute the cheapest hedge for the scheme.
Through this evolutionary step, an LDI manager can use the large pools of collateral at his disposal to support a synthetic allocation to equities through futures overlay programs. This means a scheme no longer needs to make an allocation judgement between gilts and equities and can target a higher return while still being fully hedged. The LDI manager can adjust the exposure to futures as necessary according to the required risk and return set by the scheme. Not a bad development.
The LDI manager will bring strategic ideas to the scheme’s investment committee, which may be implemented via a change to the overall benchmark. For example, one recently suggested using swaptions opportunistically when pricing became attractive; this arrangement would achieve a portion of a scheme’s interest-rate hedge, but retain some upside if interest rates were to rise in the future.
Overall, active management and strategic ideas such as these have added material value to pension funds over the last four years. Hedges have performed as expected and matched large increases in liabilities as real yields have continued to fall. The relationship with the LDI manager has become one of the most important for pension funds, with the manager expected to attend regular investment committee meetings and brief on the up-to-date level of the hedge, rebalancing activity, and any opportunities that could benefit the scheme. It is no longer the “buy-and-hold” strategy it may have seemed for some in the past.
There are still plenty of late-converters to LDI, too. Many schemes are only now embarking on a hedge-building program and are finding a tougher economic environment consisting of lower yields and probably worse funding levels to start with.
There is a silver lining though: These funds have the benefit of being able to draw upon the expanded tool set of modern LDI. They also have a larger selection of seasoned and competent LDI fund managers than the trailblazers of the mid-2000s—and now they offer increasingly competitive fees.
Yields are low. We all agree on that too. But giving LDI managers some freedom to select appropriate instruments and access a specific point on the curve gets schemes the best value. Also, seeking to secure long-term cashflows through high quality corporate debt can increase yields, so it’s not all bad news for those late to the LDI party.
LDI is not dead; if it were, UK pension schemes would be in a terrifying state. LDI continues to grow in relevance and necessity—and the evolution of the tools required is keeping pace. Pension funds now need to improve their ability to use them.
Dan Mikulskis co-manages investment consultant Redington’s ALM team. He joined in June 2012 from Deutsche Bank, Sydney, where he specialized in managing quantitative trading strategies relating to FX and equity index options. Dan began his career in the investment consulting business within Mercer, London.